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Guidance Distinguishes Tips and Service Charges

By Alistair M. Nevius, J.D.

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Tax Section

From
the IRS

The IRS issued question-and-answer guidance
for distinguishing between tips and service charges for
FICA tax purposes, the credit under Sec. 45B for the
excess employer Social Security tax an employer pays on
tips, and the rules for employer reporting of tips under
the notice and demand provisions of Sec. 3121(q) (Rev.
Rul. 2012-18).

To determine whether a payment is a
tip or a service charge, the IRS cites the factors in Rev.
Rul. 59-252. Service charges are characterized as wages
for FICA tax purposes. To be a tip:

The
payment must be free from compulsion;

The
customer must be able to determine the amount of the
payment without restriction;

The payment
cannot be negotiable or dictated by the employer; and

The customer should generally have the right
to decide who receives the payment.

If
any of the above factors is missing, there is doubt that
the payment is a tip. Nonetheless, all the surrounding
circumstances must be considered.

Rev. Rul. 2012-18
contains an example illustrating the distinction: A
restaurant policy of automatically adding an 18% charge to
the bill of parties of six or more is a service charge,
whereas a bill with sample calculations of different tip
amounts (e.g., 15%, 18%, or 20%), where the actual tip
line is left blank, is a tip.

The rest of the
questions and answers in the revenue ruling address
various issues of tip reporting, including:

How employees report tips to their employers and how
FICA taxes are paid on those tips;

Whether
employees who fail to report tips to employers are
liable for the employee FICA tax and whether any
penalties apply; and

Whether, if an
employee fails to report tips to the employer, the
employer is liable to pay the unpaid FICA tax before the
IRS makes notice and demand for payment. The rules for
notice and demand are covered in detail in Q&As 8
through 15.

According to a Memo to the
Field issued on June 7, 2012 (SBSE-04-0612-057), Rev. Rul.
2012-18 is effective immediately and retroactively.
However, because the tip versus service charge part of the
ruling described above may require businesses to change
their automated or manual reporting systems to comply, the
IRS announced that its examiners were being instructed, in
limited circumstances, to apply the rules prospectively to
amounts paid on or after Jan. 1, 2013. In Announcement
2012-25, the IRS released the memo to the public and
requested comments on the memo and whether additional time
was needed to ensure that businesses’ systems are
compliant.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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